Indexation and the Inflation Tax

by Michael R. Baye and Dan A. Black

Michael R. Baye and Dan A. Black are assistant professors of
economics at the University of Kentucky.

Executive Summary

In 1913, following the passage of the Sixteenth Amendment
to the United States Constitution, only one-half of 1 percent
of the population paid any individual income tax. The tax form
was two pages long, and it was accompanied by two pages of simple
instructions. At that time the highest marginal tax rate was
only 7 percent for those fortunate enough to earn the princely
sum of $500,000 a year, which is the equivalent today of an
annual income of over $2 million.[1]

Today, even after the tax reductions of the Economic Recovery Act of 1981, about 80 percent of the population file income
tax returns. It is not uncommon for a taxpayer to fill out 15
to 20 pages of forms, while reading several hundred pages of
IRS instructions, government publications, and privately purchased tax guides. For those families with a taxable income of
over $106,000, the marginal rate is 50 percent. In addition
the first $32,800 of wage payments are subject to the social
security (FICA) taxes, which require employers to "contribute"
7 percent and employees to "contribute" 6.7 percent of wage
income .

In addition to legislative changes in the tax code following 1913 (there have been nine revisions of the tax code since
1954), inflation has altered fundamentally the structure of the
individual income tax. During the last half of the 1970s the
inflation rate averaged 8.9 percent annually, and taxpayers
moved into higher and higher brackets as nominal incomes increased with inflation. By the end of that decade, middle class
Americans were facing marginal income tax brackets that Congress had intended for the wealthy. To combat this so-called
bracket creep, Congress in 1981 voted to index personal exemptions and rate brackets, effective in 1985, based on changes in
the Consumer Price Index (CPI) for years ending in September of
the calendar year preceding the tax year.

Recent concerns about the $200 billion budget deficit and
the inability of Congress and the Reagan administration to agree
on expenditure reductions of that magnitude have led many observers to suggest tax increases to reduce the deficit. Because
few elective officials want to be held responsible for tax increases, there has been considerable talk about eliminating the
indexation of the personal income tax that is due to begin in
1985. This measure would result in an indirect tax increase.
In addition to increasing tax revenues through the inflation
tax, the repeal of indexation would have several arbitrary
effects. By pushing more and more taxpayers into higher tax
brackets, inflation would magnify the tax distortions created
by the progressive personal income tax. In addition it would
provide an incentive for government to inflate the currency,
while most Americans prefer stable prices.

This analysis examines in some detail the effects of inflation without an indexed tax system, and it provides evidence
that the inflation tax is not a satisfactory means of raising
federal revenues. More specifically, our analysis focuses on
the history of the inflation tax and provides projections of
the inflation tax through 1990 in the event that current indexation laws are repealed.

Our evidence indicates that the inflation tax grew tenfold
during the 1970s. By 1980 the average American family needed
roughly 50 percent more income than in 1958 just to be able to
pay the inflation tax. Moreover, the inflation tax is not uniformly paid by individuals in different income classes. While
inflation pushes the poor and middle class into higher tax brackets, the wealthy remain in the 50 percent bracket. Our projections through 1990 suggest that the real tax bill of a family
with $5,000 in taxable income in 1985 will increase by 92.8
percent in just five years under an unindexed tax system and a
10 percent annual inflation rate. In contrast, the real tax
bill of a family with $200,000 in taxable income will increase
only 8.7 percent under the same conditions of five years of 10
percent inflation.

The Inflation Tax, 1947 to 1980

An inflation tax has two preconditions: inflation and a
nonindexed, progressive tax. When Americans speak of inflation,
they typically mean changes in the CPI. The CPI is a simple
price index, published monthly by the Bureau of Labor Statistics,
and measures the cost of purchasing the same group of commodities
from month to month. Because the CPI measures the cost of buying
a fixed market basket, it contains what economists call a substitution bias. [2]

The substitution bias results because consumers substitute
lower-priced goods for higher-priced ones over time. During
the 1970s, for example, consumers substituted energy-efficient
cars for their gas guzzlers as the price of gasoline skyrocketed
after the Arab oil embargo of 1973. As a result of this substitution, the CPI, being based upon the old consumption patterns
of consumers, placed too much emphasis on changes in energy
prices. This means that changes in the CPI overstated changes
in the true cost of living during the 1970s.[3]

Indeed the substitution bias causes the CPI to always over-
state the true cost of living. When measuring the magnitude of
the inflation tax, as we do in this study, it is important to
use the true-cost-of-living index rather the inflated CPI. It
also should be noted that government bases cost-of-living adjustments on changes in the CPI. As a result, the government actually overadjusts the income of individuals receiving cost-of-living
adjustments. It has been estimated by the General Accounting
Office that a 1 percent error in the measurement of inflation
can lead to $2 billion in government overpayments each year.[4]
Because taxpayers ultimately foot the bill for such overpayments,
one cost of inflation is the increased burden on taxpayers to
finance these overpayments. With a growing $200 billion budget
deficit, Congress should seriously consider indexing entitlement
programs to the true cost-of-living index rather than the CPI.

The major cost to households of inflation, however, stems
from the progressive personal income tax, and this cost is generally referred to as the inflation tax or bracket creep. When
tax payments are tied to nominal values of income, inflation
moves taxpayers into higher and higher tax brackets. Thus progressivity, initially designed to make the tax system fair,
provides tax increases without explicit congressional and presidential action. Although Congress and the president have frequently changed the tax code in attempts to reduce the burden
associated with bracket creep, their actions have been piecemeal
at best.

Although most people are familiar with the notion of bracket
creep, we believe that they would be surprised by its magnitude.
To provide a measure of the inflation tax, we used standard
econometric techniques to estimate family consumption patterns.[5]
We obtained the true cost-of-living index exclusive of changes
in taxes for the average American family between 1947 and 1980.
(Owing to date limitations we were unable to obtain figures for
the period following the Economic Recovery Act of 1981.) We
then used reported figures on the average marginal tax rates,
including individual income tax and FICA payments, for Americans
during this period.[6] This allowed us to calculate the true
cost-of-living index, including the effect of bracket creep.
Our results are reported in tables 1 through 3.

Table 1
True Cost-of-Living Index Exclusive of Taxes, 1947 to 1980

Year

Index

Year

Index

Year

Index

1947

78.5

1959

101.6

1970

131.8

1948

83.0

1960

103.1

1971

137.0

1949

82.2

1961

104.3

1972

141.9

1950

83.7

1962

105.6

1973

151.6

1951

89.4

1963

106.9

1974

167.1

1952

91.2

1964

108.2

1975

178.4

1953

92.5

1965

110.0

1976

186.7

1954

93.3

1966

113.3

1977

197.1

1955

93.5

1967

116.0

1978

211.7

1956

94.9

1968

120.4

1979

231.8

1957

97.8

1969

125.8

1980

255.3

1958

100.0

Table 1 presents the true cost-of-living index, exclusive
of taxes, for the period between 1947 and 1980. The figures
are based in terms of 1958 dollars, so that ignoring taxes, the
average American family required 155.3 percent more income in
1980 than in 1958 to afford the 1958 standard of living. This
statistic reflects the pure effects of inflation, and is similar
to the reported CPI figures, with the exception that our figures
are based on the true index that allows for substitutions among
commodities as relative prices change over time.

Table 2
True Cost-of-Living Index Inclusive of Taxes, 1947 to 1980

Year

Index

Year

Index

Year

Index

1947

77.5

1959

103.0

1970

137.2

1948

77.2

1960

104.6

1971

141.8

1949

76.0

1961

106.4

1972

148.1

1950

79.5

1962

108.2

1973

162.1

1951

89.2

1963

110.2

1974

182.3

1952

93.3

1964

107.6

1975

195.0

1953

94.4

1965

108.2

1976

207.7

1954

91.9

1966

113.7

1977

222.3

1955

93.2

1967

117.2

1978

249.6

1956

95.0

1968

127.2

1979

268.7

1957

98.3

1969

134.7

1980

303.4

1958

100.0

The rapid increase in the true cost of living exclusive of
taxes during the 1970s is attributable largely to the expansionary monetary policy during the period. We cannot overemphasize
that the numbers reported in table 1 do not reflect changes in
the total cost of living during the period because they ignore
the effects of bracket creep. Table 2, however, does include
the additional cost to Americans owing to increases in the burden of taxation. According to this table, the average American
family in 1980 required 203.4 percent more income than in 1958
to afford the 1958 standard of living after we correct for increases in federal taxes. This suggests that in 1980 one-sixth
of the income of the average American family was spent paying
the higher tax bill owing to the inflation tax brought on by
the unindexed tax system. Note that between 1976 and 1980 the
true cost-of-living index inclusive of taxes increased by nearly
100 points. This growth was significantly larger than the growth
in the true cost-of-living index exclusive of taxes during the
period, which indicates a relatively large inflation tax for
the period.

A more detailed depiction of the inflation tax is provided
in table 3, where the inflation tax is reported for the 1947-80
period. These figures give the inflation tax as a fraction of
1958 (constant standard of living) dollars.[7] The years for
which the numbers are positive indicate that the average American family faced a greater burden of taxation than in 1958;
negative values indicate that the burden of taxation was less
in that year than in 1958. The closer the value to zero, the
smaller was the inflation tax. It is interesting to note that
the inflation tax was extremely small prior to 1968. In 1967,
for example, the inflation tax amounted to only 1.2 percent of
1958 income, and before that time the tax never exceeded 3.3
percent of 1958 income (which it achieved in 1963, just prior
to the Kennedy tax cuts of 1964). Between 1968 and 1972 the
inflation tax averaged 6.4 percent of 1958 income. This was
clearly an increase over previous years, but still significantly
less than the years that followed. Between 1976 and 1980 the
inflation tax grew to an average of 33.8 percent of 1958 income,
and in 1980 it reached 48.1 percent of 1958 income. In other
words, the average American family needed 48.1 percent more income in 1980 than in 1958 just to be able to pay the inflation
tax.

Table 4
Rates of Change in Median Income and Cost-of-Living Index
Inclusive of Taxes, 1977 to 1980

Year

Change in Median Income (%)

Change in Cost of Living Index Incl. of Taxes (%)

Difference

1977

7.0

7.0

0.0

1978

11.0

12.3

-1.3

1979

9.3

7.7

1.6

1980

7.6

12.9

-5.3

Data on median income from U.S. Bureau of the Census, Money
Income of Families in the U.S. (1981).

At this point it is useful to compare recent changes in
the tax-adjusted true cost-of-living index with changes in the
median income for American families. In table 4 we present the
rates of change in median family income, the percentage change
in the cost-of-living index inclusive of taxes, and the difference between the two during the Carter administration, 1977-80.
In 1977 median income and the tax-adjusted true cost-of-living
index both increased by 7 percent. In 1978, however, the cost
of living inclusive of taxes increased 1.3 percent more than
median income; the median family suffered a fall in its real
standard of living. The median family's income, however, increased 1.6 percent more than the tax-adjusted true cost-of-
living index the next year, which made up for the previous
year's loss. The election year of 1980, though, found the true
cost of living inclusive of taxes increasing 5.3 percent more
than median family income, which undoubtedly was a factor in
President Carter's defeat. The median family experienced a
sharp decline in its standard of living.

The tremendous growth of the inflation tax between 1973
and 1980 is attributable to two factors. First, with the exception of the Volcker years, the Federal Reserve pursued a relatively easy money policy during the 1970s. Consequently, the
money supply more than doubled during the period. When the
growth in the money supply exceeds the growth in real output,
inflation results. Note that changes in the cost of living
exclusive of taxes -- the traditional measure of inflation --
also doubled during the period.

Second, revisions in the tax code during the 1970s failed
to adjust adequately the tax rates as nominal income increased
with inflation. As a result, families were pushed into higher
and higher tax brackets. The result of the inflation was a
nonlegislated tax increase that significantly increased the tax
bill of the average American family. The figures that we have
presented here tell only the story of the increased tax bills
at the federal level; to the extent that states have progressive
taxation, the actual inflation tax is larger than reported in
our study.

The Projected Inflation Tax, 1985 to 1990

We performed a simulation to illustrate the cost of repealing indexation in terms of bracket creep. The simulation is
based on the assumption that the present, nonindexed 1984 tax
codes remain in effect for the next 5 years under two alternative inflation scenarios: a 5 percent annual inflation rate and
a 10 percent annual inflation rate. We focused on six representative classes of taxable annual income in our simulation: $5,000,
$10,000, $20,000, $50,000, $75,000, and $200,000. We assumed
that the level of taxable income within each class grows at the
inflation rate.

In tables 5 and 6 we present the 1985 tax bills and marginal
tax rates for each of the above income classes. For purposes
of comparison, the 1990 tax bills and marginal tax rates are
presented under the alternative inflation scenarios. In addition, the real (inflation-adjusted) tax bills for 1990, in terms
of 1985 dollars, are also presented. For example, consider a
family of four with $5.000 in taxable income in 1985 in table

Table 5
1985 and 1990 Family Income Tax Bills Under 5 Percent

Annual Inflation Rate

1985

1990

Taxable Income($)

Tax Bill($)

Marginal Tax Rate($)

Nominal Tax Bill($)

Real Tax Bill (1985 $)

Marginal Tax Rate(%)

5,000

176

11

336.77

263.87

12

10,000

819

14

1,223.05

958.29

16

20,000

2,461

16

3,969.41

2,896.63

25

50,000

11,368

38

16,769.91

13,139.66

42

75,000

21,468

42

30,744.50

24,089.12

45

200,000

81,400

50

109,028.16

85,426.42

50

Table 6
1985 and 1990 Family Income Tax Bills under 10 Percent

Annual Inflation Rate

1985

1990

Taxable Income($)

Tax Bill($)

Marginal Tax Rate(%)

Nominal Tax Bill($)

Real Tax Bill(1985$)

Marginal Tax Rate(%)

5,000

176

11

546.36

339.25

14

10,000

819

14

1,759.92

1,092.77

18

20,000

2,461

16

5,436.86

3,375.86

25

50,000

11,368

38

23,788.71

14,770.92

42

75,000

21,468

42

42,210.24

26,209.24

49

200,000

81,400

50

142,451.00

88,450.86

50

5. The marginal tax rate for this family is 11 percent, and in
1985 it pays $176 in taxes. After five years of a 5 percent
annual inflation rate, the real (in terms of 1985 dollars) tax
bill of the family increases to $263.87, even though its nominal
income has just kept pace with inflation. Because of the inflation tax, the family's real income is reduced by $87.87 in 1990.
Note that under the 10 percent inflation scenario presented in
table 6, the real income of the family is reduced by an even
greater amount, $163.25.

To examine the burden of the inflation tax, we also calculated the percentage increase in the real tax bills owing to
the inflation tax for the alternative income classes. The results are presented in table 7. The inflation tax is remarkably
regressive in that the largest real tax increases occur for
families with lower incomes. Under both inflation scenarios
the percentage change in real taxes paid for a family with $5,000
in taxable income increases by roughly ten times as much as for
wealthy individuals in the 50 percent tax bracket. According
to table 7, the heaviest burdens of the inflation tax are borne
by poor and middle-class Americans. These results are
illustrated graphically in figure 1.

As revealed in table 7 the family with $5,000 in taxable
income has a 49.9 percent increase in real taxes between 1985
and 1990 under the 5 percent inflation rate. For the family

with $10,000 in taxable income, the 5 percent inflation rate
results in an increase of 17 percent in its real tax bill. For
a family with $20,000 of taxable income, though, the increase
in the real tax bill owing to the 5 percent inflation rate is
slightly higher, 17.7 percent. After the $20,000 mark the percentage increase in the real tax bill declines as income increases, with the family with $200,000 in taxable income experiencing an increase of only 4.9 percent in its real tax bill.

For the 10 percent inflation scenario, the results are
qualitatively similar, although the magnitude of the effects is
much larger. The percentage increases in the real tax bills of
each income class are roughly twice as large for the 10 percent
inflation scenario than for the 5 percent scenario. The real
tax bill for the family with $5,000 in taxable income increases
92.8 percent; for the family with $10,000 in taxable income,
the increase in real taxes is 33.4 percent. Once again, the
percentage increase in the real tax bill for the family with
$20,000 in taxable income is slightly larger than that for the
family with $10,000 in taxable income. And once again, after
the $20,000 mark, the percentage increase in the real tax bill
declines as income increases.

Presumably the primary reason government has adopted a
progressive income tax is because of the "fairness" of the so-
called ability-to-pay principle of taxation. Indeed, most